France, Schengen and the future of Europe - BBH

FXStreet (Guatemala) - Analysts at Brown Brothers Harriman explained that the second round of French regional elections will be held this weekend.

Key Quotes:

"The first round last weekend saw the National Front do best in terms of popular votes and led in six of the twelve regions. The National Front is not simply anti-austerity, but it is anti-EMU.

In regions that NF garnered more than 40% of the vote, the Socialists have withdrawn their candidate and urged their supporters to vote for the center-right candidate to boost the chances of defeating NF. Sarkozy, who heads up the newly-named center-right Republicans, refuses to make a similar concession. Nevertheless, when the votes are tallied, the NF is expected to win one, and possibly two regions.

This is not to downplay the regional elections. Rather the importance is that it offers a foretaste of things to come. The French presidential election is just less than a year and a half away. Although France has a parliamentary system, it is highly centralized, and the President is the key national leader. Hollande's public support has risen over since the 31 October attack, but the Socialists polled in third place national count last weekend.

The macro issues play into the NF's hands. The terrorist attack, the refugee challenge, high unemployment (no improvement under the Socialists as the unemployment rate reached an 18-year high in October of 10.6%). Some observers see the NF as blurring the "right" "left" distinctions. It is defending the extensive French welfare state (that accounts for 57% of GDP) while at the same time being nationalistic in the extreme. It sees EMU as a two-fold attack on its sovereignty. The first emanates from Brussels (that is portrayed as doing Germany bidding) and the second comes from it claims is the neoliberalism and the "dictatorship of the markets."

What the right/left mix hypothesis misses is that the mix is not new. It had a name. National Socialism. When the Great Financial Crisis hit, market participants feared left-wing socialism as numerous governments took ownership stakes in banks. There was a large expansion of the role of government (and central banks). However, at the time we warned of the greater risk of right-wing socialism, National Socialism or Fascism.

It was the Fascists that first offered the "third way" between Bolshevism and Liberalism (capitalism). None less than Hitler himself saw the linkages between socialism and Fascism. He observed in 1942 that, “There is not much difference between the basic economic techniques of socialism and fascism.”

However, when we first wrote along these lines a month after Lehman collapsed, some pushed back and noted that an essential part of Fascism was missing--some unifying hatred or racism. The refugee challenge coupled with the terrorist strike has exacerbated the xenophobia and Islamophobia that was bubbling near the surface in any event.

The refugee challenge alone prompted several countries (e.g., Germany, Sweden, Austria and Hungary) to suspend the free passage (passport-free travel). However, in light of the terrorist attack on France, a more dramatic solution has been proposed. The EU interior ministers met last week and were recommending a wider suspension of the Schengen Agreement that created a passport-free travel zone well before EMU was contemplated (Maastricht).

One of the prices of greater security is less liberty. The interior ministers also proposed the establishment of a passenger name record for planes, trains and ships. It would be not only for travel in and out of the region but also intra-EU travel. This appears to have been agreed upon back in 2008, but due to concern about privacy issues, it has not gone forward. Now it likely will.

Some observers think that without free mobility, the European project is over. Of course, many of those that are sympathetic to this argument seem to be euro-skeptics in the first place. Moreover, there are contingencies within the Schengen Agreement for precisely this. Just like in many sports, the violation of the rule are incorporated into the rules themselves, so too with many official agreements.

Article 26 of the Schengen Agreement allows member states to introduce extra checks if there are "persistent serious deficiencies" on the external borders. This condition appears to have been met. What is still apparently being negotiated is the extent of the suspension of Schengen. Some reports suggest it could be for as long as two years.

The suspension of the Schengen Agreement will likely be formally decided by the head of state summit at the end of next week. It suspension will not mark the end of the EU or EMU. Of course, it is not ideal, but it speaks to the flexibility of the institutional arrangements. It is also a useful reminder to mistrust the essentialist arguments. Observers claim this or that feature is the essence of the EU or EMU and without it, they will cease to exist. Remember the cries that the introduction of capital controls in Cyprus and now Greece were tantamount to the end of EMU. Clearly, this assessment was flawed. Both are still in EMU.

The most potent threat to the viability of the EU and EMU comes not from an agreement to re-introduce some border checks and to share more information. Instead, the bigger threat comes from the political backlash against the elites. Xenophobia and Islamaphobia are in part, the cry of some people seeing their living standards fall, and the prospects for their children diminish. The painfully slow growth, high unemployment for adults and even higher for young people fan intolerance. Populist demagogues foment such attitudes.

What seems to scare investors is not the suspension of Schengen. It is an NF victory for the French presidency which alone could tear Europe asunder. And when placed in a larger context, the changes in Europe over the next few years is particularly concerning. The changes could include the UK leaving the EU, a post-Merkel Germany, and perhaps Weidmann succeeding Draghi at the helm of the ECB.

Our bearish outlook for the euro is not predicated on this dystopia scenario. Instead, out the expectation that before the Obama dollar rally is over, the euro will test its historic lows is based on the prolonged divergence of monetary policy and the magnitude of that divergence well into 2017. We recognized the conflicting capital flows and did not expect parity to be seen this year. We do expect to see it next year and anticipate the cyclical low in 2017 or 2018. We see the political considerations discussed here as additional weights on the single currency's outlook."
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